Economic Policy Review

Federal Reserve Bank of New York December 2013 Economic Volume 19 Number 2 19 Number Volume Policy Review 1 Shadow Banking Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky 17 The Rising Gap between Primary and Secondary Mortgage Rates Andreas Fuster, Laurie Goodman, David Lucca, Laurel Madar, Linsey Molloy, and Paul Willen 41 Precarious Slopes? The Great Recession, Federal Stimulus, and New Jersey Schools Rajashri Chakrabarti and Sarah Sutherland 67 The Financial Market Effect of FOMC Minutes Carlo Rosa Economic Policy Review Editor Kenneth D. Garbade Coeditors Meta Brown Richard Crump Marco Del Negro Jan Groen Andrew Haughwout Stavros Peristiani Editorial Staff Valerie LaPorte Michelle Bailer Karen Carter Mike De Mott Anna Snider Production Staff Jessica Iannuzzi David Rosenberg Jane Urry Federal Reserve Bank of New York research publications—the Economic Policy Review, Current Issues in Economics and Finance, Staff Reports, Research Update, and the annual publications catalogue—are available at no charge from the Research Group’s website. www.newyorkfed.org/research Follow us on Twitter: @NYFedResearch Federal Reserve Bank of New York Economic Policy Review December 2013 Volume 19 Number 2 Contents Articles: 1 Shadow Banking Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky The rapid growth of the market-based financial system since the mid-1980s has changed the nature of financial intermediation. Within the system, “shadow banks” have served a critical role, especially in the run-up to the recent financial crisis. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. This article documents the institutional features of shadow banks, discusses the banks’ economic roles, and analyzes their relation to the traditional banking system. The authors argue that an understanding of the “plumbing” of the shadow banking system is an important underpinning for any study of financial system interlinkages. They observe that while many current and future reform efforts are focused on remediating the excesses of the recent credit bubble, increased capital and liquidity standards for depository institutions and insurance companies are likely to heighten the returns to shadow banking activity. Thus, shadow banking is expected to be a significant part of the financial system, although very likely in a different form, for the foreseeable future. 17 The Rising Gap between Primary and Secondary Mortgage Rates Andreas Fuster, Laurie Goodman, David Lucca, Laurel Madar, Linsey Molloy, and Paul Willen While mortgage rates reached historic lows during 2012, the spread between primary and secondary rates rose to very high levels. This trend reflected a number of factors that potentially affected mortgage originator costs and profits and restrained the pass-through from lower secondary rates to borrowers’ funding costs. This article describes the mortgage origination and securitization process and the way in which originator profits are determined. The authors calculate a series of originator profits and unmeasured costs (OPUCs) for the period 1994 to 2012, and show that these OPUCs increased significantly between 2008 and 2012. They also evaluate the extent to which some commonly cited factors, such as changes in loan putback risk, mortgage servicing rights values, and pipeline hedging costs, contributed to the rise in OPUCs. Although some costs of mortgage origination may have risen in recent years, a large component of the rise in OPUCs remains unexplained, pointing to increased profitability of originations. The authors conclude by discussing possible drivers of the rise in profitability, such as capacity constraints and originators’ pricing power resulting from borrowers’ switching costs. 41 Precarious Slopes? The Great Recession, Federal Stimulus, and New Jersey Schools Rajashri Chakrabarti and Sarah Sutherland While only a sparse literature investigates the impact of the Great Recession on various sectors of the economy, there is virtually no research on the effect on schools. This article starts to fill the void. The authors make use of rich panel data and a trend-shift analysis to study how New Jersey school finances were affected by the onset of the recession and the federal stimulus that followed. Their results show strong evidence of downward shifts in total school funding and expenditures, relative to trend, following the recession. Support of more than $2 billion in American Recovery and Reinvestment Act funding seems to provide a cushion in 2010: While funding and expenditures still fall relative to pre-recession levels, they decline less than in 2009. The infusion of federal funding coincides with significant cuts in state and local support, and the authors mark sharp changes in New Jersey’s relative reliance on the three sources of aid. An examination of the compositional shift in expenditures suggests that the stimulus may have prevented declines in categories linked most closely to instruction. Still, budgetary stress seems to have led to sizable layoffs of nontenured teachers, resulting in an increase in median teacher salary and median experience level. Furthermore, high-poverty and urban school districts were found to sustain larger resource declines than more affluent and less populated districts did in the post-recession era. The study’s findings offer valuable insight into school finances during recessions and can serve as a guide to aid future policy decisions. 67 The Financial Market Effect of Central Bank Minutes Carlo Rosa The influence of the Federal Reserve’s unanticipated target rate decisions on U.S. asset prices has been the subject of numerous studies. More recently, researchers have looked at the asset price response to statements issued by the Federal Open Market Committee (FOMC). Yet, despite a vast and growing body of evidence on the financial market effect of monetary news released on FOMC meeting days, little is known about the real-time response of U.S. asset prices to the information contained in central bank minutes. This article fills the gap by using a novel, high- frequency data set to examine the effect of the FOMC minutes release on U.S. asset prices— Treasury rates, stock prices, and U.S. dollar exchange rates. The author shows that the release significantly affects the volatility of U.S. asset prices and their trading volume. The magnitude of the effects is economically and statistically significant, and it is similar in magnitude to the Institute for Supply Management manufacturing index release, although smaller than that of the FOMC statement and nonfarm payrolls releases. The asset price response to the minutes, however, has declined in recent years, suggesting that the FOMC has become more transparent by releasing information in a timelier manner. Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky Shadow Banking • Shadow banks are financial intermediaries 1.Introduction that conduct maturity, credit, and liquidity transformation without explicit access to central hadow banking activities consist of credit, maturity, bank liquidity or public sector credit guarantees. Sand liquidity transformation that take place without direct and explicit access to public sources of liquidity or • The banks have played a key role in the credit backstops. These activities are conducted by specialized market-based financial system, particularly financial intermediaries called shadow banks, which are in the run-up to the financial crisis. bound together along an intermediation chain known as the shadow banking system (see “The Shadow Banking 1 • This study describes the institutional features System” Online Appendix). of shadow banks, their economic roles, and In the shadow banking system, credit is intermediated through a wide range of securitization and secured funding their relation to traditional banks. techniques, including asset-backed commercial paper (CP), asset-backed securities (ABS), collateralized debt obligations • The authors suggest that increased capital and (CDOs), and repurchase agreements (repos). While we believe liquidity standards for depository institutions the term “shadow banking,” coined by McCulley (2007), to be and insurance companies will likely heighten a somewhat pejorative name for such a large and important the returns to shadow banking activity. part of the financial system, we have adopted it for use here. Prior to the 2007-09 financial crisis, the shadow banking • Shadow banking, in some form or another, is system provided credit by issuing liquid, short-term liabilities therefore expected to be an important part of against risky, long-term, and often opaque assets. The large the financial system for the foreseeable future. amounts of credit intermediation provided by the shadow banking system contributed to asset price appreciation in residential and commercial real estate markets prior to the financial crisis and to the expansion of credit more generally. 1 This article is complemented by a series of online appendixes (listed in the box on the next page). Zoltan Pozsar is a senior advisor at the U.S. Treasury Department’s Office This study was first published as Federal Reserve Bank of New York staff of Financial Research; Tobias Adrian is a vice president and Adam Ashcraft report no. 458, July 2010 (www.newyorkfed.org/research/staff_reports/ a senior vice president at the Federal Reserve Bank of New

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